Archive for August, 2007

A federal judge refused to grant protection from U.S. lawsuits for Bear Stearns Cos.’ two bankrupt hedge funds, finding the Cayman Islands was not the proper jurisdiction for them to liquidate assets.

U.S. Bankruptcy Judge Burton Lifland today said the funds’ filings in the Caymans didn’t make them eligible for the protection under a provision of the federal bankruptcy law designed to assist foreign companies liquidating overseas. He continued a temporary ban on such suits, telling the funds they could liquidate or reorganize in the U.S., winning an automatic ban on such suits.

“The only adhesive connection with the Cayman Islands that the funds have is the fact that they are registered there,” Lifland wrote in a ruling in New York, noting that most fund assets were in the U.S.

Bear Stearns’ funds had requested protection from U.S. suits under Chapter 15 of the bankruptcy code, arguing in part that their Cayman Islands liquidation could meet the law’s standard as a “foreign main proceeding.”

Lifland rejected that idea and also denied a request by the funds to impose a suit ban by considering the Caymans as a “non- main” site of their planned liquidation. He found the funds failed satisfy the legal requirement that they had a “place of operations where the debtor carries out nontransitory economic activity.”

“There are no employees or managers in the Cayman Islands, the investment manager for the funds is located in New York, the administrator that runs the back-office operations of the funds is in the United States along with the funds’ books and records, and prior to the commencement of the foreign proceeding, all of the funds’ liquid assets were located in the United States,” Lifland wrote.
Hedge funds that are technically incorporated outside the U.S. but have their true operations or assets inside the country may be ineligible for Chapter 15, said Kurt Mayr, a lawyer in the financial-restructuring group at Bracewell & Giuliani in Hartford, Connecticut. Funds unable to pay debts may have to reorganize under Chapter 11 of the U.S. bankruptcy law or liquidate under Chapter 7, he said.
Fred Hodara, a lawyer for New York-based Bear Stearns, the fifth largest U.S. investment firm by market value, didn’t immediately return a call for comment.

Problems in the credit markets coupled with a sharp drop in equity markets have affected many hedge fund returns. As many managers in the loosely regulated $1.75 trillion industry suffer more losses in August, speculation mounts that more funds could be on the brink of shutting down.

Following is a list of firms whose hedge funds have recently posted losses or have been shut down entirely, their location, and a description of their troubles:

— Basis Capital (Australia) – The firm’s Basis Yield Alpha Fund files for bankruptcy protection in the United States on Aug. 29 amid mounting losses from U.S. subprime mortgage assets. Earlier the group suspended redemptions on two of its funds and appointed U.S.-based Blackstone Group to help prevent a fire sale of assets. In mid-August the group said that one of its portfolios had lost more than 80 percent.

— Bear Stearns Cos (United States) – Two Bear Stearns funds which invest in collateralized debt obligations — bonds comprising repackaged mortgages — by mid-June are trying to sell about $4 billion in bonds to raise cash for redemptions. Major investment banks seize assets or unwind positions. Bear eventually bails out one of the funds and lets the other one fail. In late July, Bear Stearns halts redemptions at a third hedge fund.

— Absolute Capital (Australia) – Half-owned by Dutch bank ABN AMRO. Temporarily closes two funds in late July with a combined A$200 million in assets amid problems with collateralized debt obligations.

— Macquarie Bank (Australia) – The bank warns in early August that retail investors in two of its debt funds face losses of up to 25 percent.

— Oddo Asset Management (France) – The French financial services company in late July closes its Oddo Cash Titrisation, Oddo Cash Arbitrages and Oddo Court Terme Dynamique funds, which manage total assets of around 1 billion euros.

— Sowood Capital Management (United States) – The hedge fund which managed money for Harvard University tells investors on July 30 that it will wind down after suffering losses of more than 50 percent which wiped out roughly $1.5 billion in capital.

— Caxton Associates (United States) – The fund managed by industry veteran Bruce Kovner takes the unusual step of sending a letter to clients to assure them that market rumors about out-sized losses were false. The flagship Caxton Global fund is down about 3 percent in July but remains in the black for the year.

For the mortgage industry, Wall Street’s big investment banks might seem like one of those friends who disappear when the going gets tough.

It wasn’t that long ago that the investment houses, looking for ways to cash in on the then-booming housing industry, were buying mortgage lenders at a frenetic pace.

The story now is quite different. This past week, 1,200 people lost their jobs after Lehman Brothers Holdings Inc. closed subprime-lending unit BNC Mortgage LLC, a company it fully acquired in 2004. Similar steps are expected as investment banks try to erase any connection with loans to borrowers with weak credit.

“The mortgage industry has always viewed Wall Street as fair-weather friends, active when things are good and abandoned when times are bad,” said Guy Cecala, publisher of trade publication Inside Mortgage Finance. “We’re just at the beginning of them pulling away from mortgage operations, and the ones that are not closed down will be cut back severely.”

Cecala, whose subscriber base is dwindling as mortgage bankers are laid off, said the investment banks are mostly looking after their image on the Street — shedding these mortgage units is an easy way to bolster investor confidence. Many of the takeovers were completed at bargain prices, and unwinding them will have little impact on earnings.

Investment banks’ stocks have been hurt by the defaults and delinquencies on subprime loans, which sent the overall stock market falling but in particular pummeled financial companies. For the most part, it hasn’t threatened the health of the companies, although Bear Stearns Cos. took a harder hit after disclosing that two hedge funds it managed collapsed because of investments in mortgage-backed securities. Its stock, which has since recovered somewhat, fell about 33 percent and wiped about $5 billion in market value.

Those mortgage-backed securities are one of the reasons investment banks wanted to buy subprime mortgage lenders. The banks originate the loans, then bundle them together and sell them as securities to institutional investors.

More than 50 lenders have already gone bust since June and trading in the once-lucrative secondary mortgage market has dried up.

Lehman Brothers said it will take a $52 million charge for closing BNC when it reports third-quarter earnings next month — hardly anything when compared to the investment bank’s record profit of $4 billion last year. The company said it would continue to offer loans through its Aurora Loan Services, which it full acquired in 2003.

“The closure of this has greater implications than simply shuttering a business during a cyclical downturn,” said Richard X. Bove, an analyst with Punk Ziegel & Co. “The nature of the mortgage banking business is to boom and then go bust and then boom one more time.”
Analysts believe Lehman got out of the subprime business fairly cheaply, especially since it has held a stake in BNC for a number of years before buying it. Others might not be so lucky.

Merrill Lynch, the nation’s largest brokerage, acquired First Franklin Financial Corp. from Cleveland-based National City Corp. for $1.3 billion in 2006. Merrill Lynch declined to comment about First Franklin Financial, but Chief Financial Officer Jeff Edwards told analysts during the second quarter that it has taken steps to curb losses in its subprime loan portfolio through risk management.

Bear Stearns operates subprime lender Encore Credit, which it acquired in the past year for about $26 million. It also owns Bear Stearns Residential and EMC Mortgage Corp. The nation’s fifth-biggest investment bank laid off about 240 workers earlier this month from its mortgage businesses.

Morgan Stanley bought Saxon Capital in 2006 for about $706 million, Credit Suisse acquired subprime lender Lime Financial Services in April, and Barclays PLC bought EquiFirst Corp. for $225 million that same month. Deutsche Bank bought MortgageIT in 2006 for about $429 million last year.

Barclays and Deutsche Bank did not return telephone calls seeking comment, and the other banks declined to comment.

Investors are expected to hit hedge funds with a flood of redemption requests this fall, but those who try to withdraw their money may be in for an unpleasant surprise.

Most hedge funds have “lock-ups,” a minimum period of time during which investors agree to tie up their money and not make any withdrawals.

Once that period ends, investors generally can redeem their stakes as long as they give advance notice, usually 45 to 90 days before the quarter end. Although that cut-off has passed for many funds for the current quarter, investors can still put in requests to get their money out by year-end.

But hedge funds also can slow withdrawals, or suspend them altogether. While they’re usually loath to do this, since it can signal that a fund is on the verge of collapse, current conditions may result in more funds not letting investors take their money out – at least not immediately.

Hedge funds have been hard hit by the recent turmoil in the market. Two Bear Stearns hedge funds heavily invested in securities backed by subprime mortgages blew up in June. Ensuing volatility claimed funds at Sowood Capital Management and led to big losses at so-called quantitative funds, including some run by Goldman Sachs and others.

The losses sparked panic in the market, as well as worries that more problems will surface at other funds. That’s raised expectations that hedge-fund investors, which include institutions like university endowments and pension funds, will try to rush to get their money out before losing more. That, in turn, can unleash a vicious cycle: As hedge funds lose cash, they’re left with less money to invest, which can make it difficult for the funds to recover and hasten a downward spiral.

To avoid that scenario, hedge funds can make it tougher for nervous investors to bail out. For example, they can slow redemptions by imposing a “gate,” which allows them to cap the amount investors withdraw during a given period – usually at 20 percent of the fund’s net asset value, according to David Nissenbaum of law firm Schulte Roth & Zabel, whose hedge-fund practice dominates the industry.

They can also block withdrawals completely, for instance when they can’t accurately value the fund’s assets or don’t have the money to meet requests, legal experts say. Bear Stearns froze withdrawals on a third fund this month, although the reason for the suspension was unclear.

In 2000, Standard & Poor’s made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a “piggyback,” where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage.

While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a movement that transformed America’s home-loan industry: a boom in “subprime” mortgages taken out by buyers with weak credit.

Six years later, S&P reversed its view of loans with piggybacks. It said they actually were far more likely to default. By then, however, they and other newfangled loans were key parts of a massive $1.1 trillion subprime-mortgage market.

Today that market is a mess. As defaults have increased, investors who bought bonds and other securities based on the mortgages have found their securities losing value, or in some cases difficult to value at all. Some hedge funds that feasted on the securities imploded, and investors as far away as Germany and Australia have suffered. Central banks have felt obliged to jump in to calm turmoil in the credit markets.

It was lenders that made the lenient loans, it was home buyers who sought out easy mortgages, and it was Wall Street underwriters that turned them into securities. But credit-rating firms also played a role in the subprime-mortgage boom that is now troubling financial markets. S&P, Moody’s Investors Service and Fitch Ratings gave top ratings to many securities built on the questionable loans, making the securities seem as safe as a Treasury bond.

Also helping spur the boom was a less-recognized role of the rating companies: their collaboration, behind the scenes, with the underwriters that were putting those securities together. Underwriters don’t just assemble a security out of home loans and ship it off to the credit raters to see what grade it gets. Instead, they work with rating companies while designing a mortgage bond or other security, making sure it gets high-enough ratings to be marketable.

The result of the rating firms’ collaboration and generally benign ratings of securities based on subprime mortgages was that more got marketed. And that meant additional leeway for lenient lenders making these loans to offer more of them.

The credit-rating firms are used to being whipping boys when things go badly in the markets. They were criticized for being late to alert investors to problems at Enron Corp. and other companies where major accounting misdeeds took place. Yet they also sometimes get chastised when they downgrade a company’s credit.

Fund managers and banks are under scrutiny for their methods in valuing illiquid securities, after some funds admitted they’re having trouble putting a price on complex debt instruments backed by residential mortgages and corporate loans.

Units of French bank BNP Paribas SA (BNPQY) and insurer AXA SA (AXA) have suspended redemptions on some of their funds because they said they couldn’t value them accurately, while the U.S. Securities and Exchange Commission is reportedly checking the books of U.S. brokerage firms and banks to make sure they aren’t hiding losses by misvaluing assets linked to subprime mortgages.

On Tuesday, Sentinel Management Group, a firm managing short-term cash for commodity trading firms and hedge funds, also halted client redemptions because it said it couldn’t meet them “without selling securities at deep discounts to their fair value.” The firm invests in government and corporate securities.

The lack of confidence in how funds and banks are valuing their subprime exposure – and fear that future risks haven’t been accounted for – has already led to a wave of fund redemptions by investors and a sell-off in some banks’ shares.

The securities in question are known as collateralized debt obligations, or CDOs, and are widely held by banks, insurers, pension funds and investment funds. Backed by large pools of mortgages, loans or other interest-bearing assets, these securities played an instrumental role in fueling cheap credit to home buyers, companies and other borrowers over the past several years.

The breakdown in valuing them is just one effect of the wider credit crisis that started with a sharp and unexpected rise in the number of U.S. homeowners defaulting on their mortgages.

The losses hit CDO portfolios stuffed with risky mortgages, and some funds holding CDO securities became forced sellers to meet margin calls. Investors lost their confidence in the vehicles’ underlying assumptions about default rates, and the trading value of CDOs has tumbled across the board, whether they are exposed to defaulting mortgages or not.

Residential mortgage delinquencies and defaults are becoming more common among borrowers in the category just above subprime, American International Group (NYSE: AIG) said on Thursday.

In a presentation on its subprime exposure, AIG, the world’s largest insurer and one of the biggest mortgage lenders, said total delinquencies in its $25.9 billion real estate portfolio were 2.5 percent. It said 10.8 percent of its subprime mortgages were 60 days overdue, compared with 4.6 percent in the category with credit scores just above subprime, indicating that the threat to the mortgage market may be spreading.

Bear Stearns Cos.’ decision to liquidate two bankrupt hedge funds in the Cayman Islands instead of New York may limit creditors’ and investors’ ability to get their money back.

While most of their assets are in New York, the funds filed for bankruptcy protection July 31 in a court in the Caymans, where they are incorporated. The bank also used a 2005 bankruptcy law to ask a U.S. judge in Manhattan to block all lawsuits against the funds and protect their U.S. assets during the Caymans proceedings.

The Bear Stearns cases may establish a precedent that would let other failed hedge funds liquidate in the Caymans, where judges have a track record of favoring management. The local monetary authority estimates that three out of four hedge funds globally are incorporated in the islands.

Wall Street investment bank and brokerage Bear Stearns overhauled its top management ranks at the weekend, but its shares continued to fall Monday amid concerns about its exposure to mortgage-related securities.

The bank’s president and co-chief operating office Warren Spector announced his resignation from Bear Stearns on Sunday as the bank said it had appointed company veteran Alan Schwartz as its sole president.

Samuel Molinaro, Bear Stearns chief financial officer, will take over the chief operating officer’s role while another executive, Jeffrey Mayer, will take Spector’s seat on the firm’s executive committee.

Bear Stearns, which traces its history to 1923, has endured a couple of difficult months.

The firm told investors in June that “challenging market conditions” roiling the US housing market had contributed to a hefty 21 percent drop in its fixed income revenues during the second quarter to 962 million dollars.
The problems forced it to wind down two hedge funds it had managed which had been heavily invested in complex mortgage-related securities.

Bear Stearns Cos., the manager of two hedge funds that collapsed last month, blocked investors from pulling money out of a third fund as losses in the credit markets expand beyond securities related to subprime mortgages.

The Bear Stearns Asset-Backed Securities Fund had less than 0.5 percent of its $900 million of assets in securities linked to subprime loans, spokesman Russell Sherman said in an interview yesterday. Even so, investors concerned about losses sought to withdraw their money, he said.

Shares of New York-based Bear Stearns fell as much as 6 percent, pushing some brokerage stocks lower on concern about shrinking profits from debt underwriting and trading. Bear Stearns triggered a decline in credit markets in June, when funds it managed faltered after defaults on home-loans to people with poor credit rose to a 10-year high.

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